implementing activity based costing

7/28/2019 Implementing Activity Based Costing

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Statements on Management Accounting

S T R A T E G I C C O S T M A N A G E M E N T

C R E D I T S

T I T L E

IMA would like to acknowledge the work of Gary Cokins

([email protected]),performance management solu-

tions manager, SAS, on whose work this SMA is based

and Raef Lawson, research director, IMA, who served as

reviewer.

ImplementingActivity-Based Costing

Published byInstitute of Management Accountants10 Paragon DriveMontvale, NJ 07645www.imanet.org 2006 Institute of Management Accounting


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Statements on Management Accounting

T A B L E O F C O N T E N T S

Implementing Activity-Based Costing


I. RationaleWhat Leads to Interest

in ABC? . . . . . . . . . . . . . . . . . . . . . . . . 1

II. Scope . . . . . . . . . . . . . . . . . . . . . . . . . 2

III. Defining ABC . . . . . . . . . . . . . . . . . . . . . .3

IV. The Role of the Management Accountant .4

V. Implementing ABC Involves Behavioral

Change Management . . . . . . . . . . . . . . .5

VI. Planning for an ABC Implementation . . . . .6

VII. Initial Design of the ABC System . . . . . . .8

VIII. Strategic vs. Operational Cost

Management . . . . . . . . . . . . . . . . . . . .15

IX. Customer Profitability Reporting . . . . . . .18

X. ABC Project Planning . . . . . . . . . . . . . .22

XI. Collecting ABC Data . . . . . . . . . . . . . . .22

XII. Implementing the Final ABC System . . .27

XIII. Ensuring Successful Use as aSustainable System . . . . . . . . . . . . . . .29

XIV. Commercial ABC Software . . . . . . . . . .29

XV. Conclusion . . . . . . . . . . . . . . . . . . . . .30

Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

Bibliography . . . . . . . . . . . . . . . . . . . . . . . .31

Exhibits

Exhibit 1: Indirect Costs Are Displacing

Direct Costs . . . . . . . . . . . . . . . .2

Exhibit 2: The Activity-Based Cost Management

Framework . . . . . . . . . . . . . . . . . .9

Exhibit 3: Each Activity Has Its Own Activity

Driver . . . . . . . . . . . . . . . . . . . .10

Exhibit 4: Multi-Level Cost Assignment Flow .12

Exhibit 5: ABC Cost Assignment Network . . .14

Exhibit 6: Profitability Profile Using ABC

Profit Cliff . . . . . . . . . . . . . . . .15

Exhibit 7: Fully Traced Costs to a Cost

Object . . . . . . . . . . . . . . . . . . . .17

Exhibit 8: ABC Profit Contribution Margin

Layering . . . . . . . . . . . . . . . . . . .19

Exhibit 9:

ABC Customer Profit & LossStatement . . . . . . . . . . . . . . . . .20

Exhibit 10: Migrating Customers to Higher

Profitability . . . . . . . . . . . . . . . . .21

Exhibit 11: Process View . . . . . . . . . . . . . . .25

Exhibit 12: Final Cost Object View . . . . . . . . .26

Exhibit 13: ABC Rapid Prototyping with

Iterative Remodeling . . . . . . . . . .27


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I . RAT ION ALEWHAT LEAD S TOINTEREST IN ABC?There is a growing desire among organizations to

understand their costs and the behavior of fac-

tors that drive these costs. Yet there is confu-

sion over how to go about understanding costs

and how to distinguish competing cost measure-

ment methodologies (e.g., activity-based cost-

ing, standard costing, throughput accounting,

project accounting, target costing, etc.). The

result is that managers and employees are con-fused by mixed messages about which costs are

the correct ones. Upon closer inspection, the var-

ious costing methodologies do not necessarily

compete: they can coexist, be reconciled, and

blended.

In an increasingly competitive business environ-

ment, organizations seeking to maintain or

improve their competitiveness need cost informa-

tion that is accurate and relevant. In the past,

companies planned and controlled their opera-

tions using accounting information that wasassumed to accurately reflect the costs of their

products and services (and, ideally, their channels

and customers as well). In fact, this was often not

the case. The costing systems of many compa-

nies, with their broad averaging allocation of indi-

rect costs, masked by an illusion of precision,

were actually providing misleading information to

decision makers. This resulted in suboptimal deci-

sion making by these companies managers.

In order to overcome the over-generalizations of

traditional costing systems, with their excessive-

ly simplified cost allocations and resulting lack

of visibility for indirect costs, organizations have

been adopting activity-based costing (ABC) sys-

tems. These systems are based on cost model-

ing that traces an organizations expensesboth

direct and indirectto the products, services,

channels, and customers that cause those

expenses to be incurred.

Exhibit 1 illustrates one factor that has lead to

interest in ABC. Indirect expenses are displacing

the direct expenses that make products or deliv-

er services to customers. When asked for the

cause of this displacement, most say that it is

because of technology, equipment, automation,

or computers. In other words, organizations are

automating what previously had been manualjobs. But this is only a secondary factor for

explaining the shift in the type of organizational

expenses. The primary cause for the shift is the

gradual proliferation in the types of products and

service lines. Over the last few decades, most

organizations have been offering an increasingly

greater variety of products and services and

using more types of distribution and sales chan-

nels. In addition, organizations have been servic-

ing more and different types of customers.

Introducing this greater variation and diversity

(i.e., heterogeneity) creates complexity, andincreasing complexity results in greater overhead

expenses. The fact that the overhead component

of expense is displacing the recurring labor

expense does not automatically mean that an

organization is becoming inefficient or bureau-

cratic. It simply means that a company is offer-

ing more variety to different types of customers.

The problem with traditional costing is that the

increasingly large amount of indirect expenses

continues to be allocated using allocation fac-

tors that are typically unrelated to what causes

the costs to be incurred. The consumption of

resources needs to be traced and assigned as

costs based on cause and effect relationships

and that is what ABC does.

Here is a simple way to understand the basic

principles of ABC. Imagine that you and three

friends go to a restaurant. You order a small

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salad and they each order the most expensive

item on the menua prime rib steak. When the

server brings the bill, the others say, Lets splitthe check evenly. How would you feel? You

would feel this is unfair and inequitable. This is

similar to the effect on the calculated cost of

many products and service lines in a traditional

cost accounting system where the accountants

take a large amount of indirect expenses and

allocate them as costs without any logic. There

is minimal or no relationship to how the products

or service lines uniquely consumed the expens-

es. This likely results in distorted product costs.

ABC avoids this problem. In the restaurant exam-

ple, ABC is equivalent to the server providing

four individual checkseach patron is charged

for what he or she individually consumes.

Many organizations have evolved beyond using

ABC solely for obtaining more accurate and rele-

vant costing information. For these companies,

the emphasis has shifted from ABC to ABM

activity-based management. These organizations

use an understanding of their cost driversthe

measures of activity that are causal factors inthe incurrence of costto improve their opera-

tions. They use their improved understanding of

their cost structure, which is now more highly vis-

ible, to proactively manage their resources to

enhance the key elements of value from their

customers perspective. (For more information,

see IMAs Statements on Management

Accounting (SMAs) Implementing Activity-Based

Management: Avoiding the Pitfalls and Tools and

Techniques for Implementing ABC/ABM.)

Organizations involved in business process

reengineering, quality improvement, and lean

management initiatives use both the financial

and nonfinancial insights from ABC as a

measurement system.

I I . SCOPEThis SMA provides an overview of the approach

to designing and implementing an ABC system.

2


Cost

Components

Stages in the Evolution of Business

Changes in Cost Structure

100%

0%

Overhead

(indirect expense)

Direct (recurring) Labor

Old-fashioned Hierarchical Integrated

Trace

and assign,

not

allocate.

1990s1950s

DirectMaterial

EXHIBIT 1. INDIRECT COSTS ARE DISPLACING DIRECT COSTS

Source: Gary Cokins.


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The principles contained in this SMA are applica-

ble to any organization, regardless of size or

industry. It provides those considering implement-

ing an ABC system with information regarding:

G The roles and responsibilities of management

accountants in ABC projects;

G The need for behavior change management

when implementing an ABC system;

G How to design and implement an ABC system;

G How to plan an ABC project implementation;

G How to ensure sustainability of an ABC system;and

G How to evaluate ABC software.

The information in this SMA will enable the read-

er to design and implement a sustainable ABC

system that provides a greater understanding of

product and customer costs, business process-

es, and work activities. This understanding pro-

vides an organization with the means for making

better business decisions.

I I I . DEF IN ING ABCTraditional costing methodologies and ABC differ

in the following way:

Traditional cost accounting techniques

allocate indirect expenses to products

(and to any cost object) based on charac-

teristics of a single allocation factor that

is typically not causally related to the type

and level of work consumed.1 Traditional

cost allocation factors include the num-

ber of direct labor hours required to man-

ufacture a unit, the cost of that direct

labor, the purchase cost of merchandise

resold, or the number of days occupied.

These are broad averages that do not

reflect causality for the indirect expenses.

The problem is that use of these alloca-

tion methods results in allocations that

vary with changes in the allocation basis.

ABC systems recognize that individual

products or customers do not consume

indirect expenses in those proportions.

Instead, they focus on the work activitiesof people and equipment required to pro-

duce each product or provide each ser-

vice, and their consumption of each of

those activities.

As an example of the cost distortion from apply-

ing broadly averaged overhead rates, consider a

semiconductor plant that once calculated its

product costs by taking direct labor and direct

material and then added 1600% of these costs

as an allocation of overhead costs. Compared to

this standard cost allocation method, however,the companys various products consumed the

overhead very disproportionately. The result was

product cost distortions of over 500% relative to

the organizations beliefs. The profitability of the

companys various products and services was

very different from what it believed to be the

case.

ABC traces indirect costs (commonly called

overhead) to products, services, and cus-

tomers by identifying resource and their costs,

the consumption of these resources by activi-

ties, and the performance of activities to pro-

duce output. Examples of resource expenses are

salaries, operating supplies, equipment depreci-

ation, and electrical power. They represent the

capacity to perform work.

3


1 A cost object is a function, organizational subdivision, con-tract, product, or other work unit for which cost data is desiredand for which provision is made to accumulate and measurethe cost of processes, products, jobs, capitalized projects,etc. Intermediate cost objects are internal to a company,while final cost objects are products, standard service lines,or the cost-to-serve customers that generally touch externalentities. Organizational sustaining final cost objects are thosenot caused directly by suppliers, products, channels, or cus-tomers. Senior management and regulatory bodies are exam-ples. Cost objects can be thought of as for what or for whomwork is done.


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ABC gives visibility to work activities and their

costs. Activities are a group of tasks in the same

function that are governed by the same driver

and same intensity of resource consumption.

The activities performed by an organization are

identified using activity analysis. This involves

determining what activities are done within the

department, how many people perform the activ-

ities, how much time they spend performing the

activities, what resources are required to per-

form the activities, what operational data bestreflect the performance of the activities, and the

value of the activities to the organization.

With ABC, resources are traced to activities

using resource drivers; these are used to calcu-

late the cost of each activity that consumes the

resources. Activity costs are then traced, using

activity drivers, to each product or service (i.e.,

cost object) that consumes a given activity. This

is done by determining how many units of activi-

ty output each cost object consumed during any

given period of time. (The topic of drivers canbe confusing; definitions and examples of driv-

ers will be discussed in Section VII.)

ABC originated in the manufacturing sector, but

subsequent implementations by organizations in

virtually every sector of the economy have

demonstrated its universal applicability. For

example, many governmental units and compa-

nies in the financial services industry now use

ABC systems to determine customer profitability.

I V. THE ROLE OF THEMANAGEMENT ACCOUNTANTAs with any new management technique, buy-in

from the executive team is crucial to the imple-

mentation of an ABC system. Also essential is

the support of an organizations management

accounting staff. These professionals need to

understand that their existing costing system

which they have a vested interest in maintain-

ingis most likely producing inaccurate and mis-

leading costing information. It is essential that

adequate communication take place to demon-

strate to the accounting staff that a better alter-

native existsone that provides operational-

relevant information and enhances the quality of

the information they provide to managers.

Management accountants can perform an impor-

tant role in the design of an ABC system. Basedon their skills and training, they can help identify

what is appropriate for analysis (product, cus-

tomer, process, etc.) and explain the probable

causes of an existing cost systems deficiencies.

In addition, based on their detailed knowledge of

the information in their companys costing infor-

mation systems, they are uniquely qualified to

judge the level of aggregation appropriate to the

ABC costing system. They can use their under-

standing of costing methods to recommend

appropriate methodologies for the assignment of

costs to activities and cost objects. Finally, theywill be able to use their understanding of the

information and cost relationships to support

the system once it is implemented.

A few notes of caution and a qualifier: ABC cal-

culates historical costs to provide insights,

understanding, and focus. ABC is basically full

absorption costing but without violating rules of

causality as is typically done with traditional cost

allocations of indirect expenses. But decisions

impact the future. To validate the expected finan-

cial impact of a decision, one should apply man-

agerial economics that involve marginal cost

analysis that classifies the behavior of expenses

with respect to changes in mix and volumes as

being variable, semi-variable, step-fixed, or fixed

(or include that capability in the ABC model).

Such analysis should also distinguish the differ-

ence between capacity provided and capacity

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used and consider the presence of unused and

available capacity. Full absorption costing in an

ABC context does not mean that 100% of a peri-

ods expenses are traced to customer-related

products, services, and channels. Costs not

related to customers, including unused capacity

expenses, are ideally traced to a final cost object

called business sustaining costs (described in

Section VII).

When the impact of decisions are less obviousand require validation, marginal cost analysis

methods (such as resource consumption

accounting and activity-based resource planning)

or capital investment analysis using discounted

cash flow (DCF) should be applied. With ABC,

marginal cost analysis and capital justification

techniques apply various versions of past period

costs that can be layered according to which

resource expenses are to be included or exclud-

ed depending on the type of decision being made

and the planning horizon. Determining which

expenses to include or not in decision analysiscan be judgmental, such as the cost of unused

capacity. This SMA addresses how to more accu-

rately calculate what something costs today and

gives insight as to what expenses may be

required in the future based on various forecasts.

It is the role of management accountants to

determine which assumptions to make as they

support their organization in decision analysis.

Another caution about limitations of ABC data

involves life-cycle costing. The descriptive view of

ABC typically covers a time period such as a

month, quarter, or year. Products and customers,

however, pass through life cycles. ABC may

measure unusually high product costs during a

products early stages, when it requires attention

to stabilize production. The product may appear

unprofitable today but be profitable in the future

as those costs subside. The lesson here is that

ABC does not calculate the multi-period costs

across a life cycle, but its cost snapshots during

each period can be used as inputs for life-cycle

costing.

V. IMPLEMENTING ABCINVOLVES BEHAVIORALCHANGE MANAGEMENTAs with any new management technique or tool,

an effective change management process must

be in place before implementing an ABC system.An objective of this process should be to ensure

that there is support for the system at all levels

of an organization. This includes having a top-

level manager to champion the initiative, as well

as acceptance by lower-level managers. The

acceptance by these later managers often can

be obtained by demonstrating that in most cases

the existing cost accounting system produces

distorted, and thus misleading, information. This

distortion often arises because an existing cost-

ing system does not reflect the increasing com-

plexity of an organization and the products andservices it offers. By implementing a costing sys-

tem that reflects that complexityand provides

the operational information necessary for man-

aging a companys operationsmanagers can

see the increased relevance of the information

provided for managerial decision making and

enhanced performance management.

The change management process needs to

specifically address the people issues that will

arise in the implementation of the new costing

system. This includes addressing commitment

to the existing system that various managers

may have, and their reluctance to change. It is

also important to address the effect of the new

system on performance measurement and com-

pensation systems. New performance metrics

may need to be devised, or existing ones

revised, based on information obtained during

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the ABC system implementation. An example of

an effect of reporting the new cost data from

ABC is the shift in costs among products. Some

products that were effectively subsidizing others

will now be reported with lower costs and higher

profit margins. The opposite effect will occur with

other products, which will now show lower profit

margins or even losses.

Effective communicationat all levels of an

organizationof the need for change is essen-tial. An organization needs to communicate the

deficiencies of its existing costing system, the

effect of this distortion on managerial decision

making, how ABC costing principles can be used

to provide information that is more relevant for

managerial decision making, and the effect of

the new system on the evaluation and rewarding

of individual employees. Communication is a

two-way process, and employee concerns need

to be addressed.

Implementation of an ABC system needs to bejustified on a cost-benefit basis, just as with any

other investment. Yet the value of having better

decision-making information can be difficult to

measuremore so than, say, the benefits from

an investment that is more tangible, such as the

purchase of a piece of machinery. The key is that

the benefits from having the improved costing

information exceed the extra administrative

effort to produce it. That is, the following equa-

tion must be satisfied:

By demonstrating that the equations numerator

is much higher than people realize and that the

denominator can be kept low by being practical

(e.g., using estimates and only minimal extra

data collection), the perceived ratio can be shift-

ed from below 1 to above it (and very likely well

above it).

One ABC implementation technique introduced

in the 1990s that radically accelerated the time

to implement ABC, improved the ABC model

design, and minimized the risk that a project may

run into problems caused by excessive detail

and complexity is called ABC rapid prototyping

with iterative remodeling. This technique

assures that the denominator in the benefits tocost ratio is kept small. It also raises the numer-

ator by revealing more unrecognized benefits.

This approach is discussed in Section XII. ABC

rapid prototyping can lead to a production ABC

system being created in weeks, not years, and

with minimal support.

VI . PLANNING FOR AN ABCIMPLEMENTATIONA guiding principle for an ABC initiative is to work

backwards, keeping the end in mind. Have a com-

pelling reason to reform the existing cost system.Know a type of decision or analysis the ABC sys-

tem will improve. In this way, an ABC implementa-

tion is no different than implementation of any

other project: before you start, you need to know

what you expect to be the final outcome. By fol-

lowing this principle, an organization can help

ensure that the ABC system it ends up with has

been designed to meet its specific needs, and

not those of some generic organization.

Numerous approaches can be taken when

designing and implementing an ABC system.

There is no generic approach that is universally

appropriate. In order to obtain proof of con-

cept, many companies, especially larger ones,

initially implement ABC using a pilot project

approach, where a segment of the organization

is selected for implementation of ABC costing

concepts.

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Incremental benefits

Incremental administrative cost >1


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The pilot project can be implemented using actu-

al revenues and expenses. If the main goal is to

gain buy-in for ABC, budgeted or planned rev-

enues and expenses may be used, but budgets

and forecasts may be substantially different than

actual results. Continuing with the pilot imple-

mentation, activities and their interrelationships,

cost drivers, and volumes are identified. Cost

attachment points are identified, and activity

costs are calculated. The consumption of activi-

ties by cost objects (such as products or cus-tomers) is identified, and the drivers and vol-

umes identified. The successes of the pilot proj-

ect can also be used to validate the business

case for implementing ABC company-wide and

provide lessons learned for subsequent rollout

of the methodology.

An organization can also opt to fully implement

ABC from the start. In this case, the ABC rapid

prototyping with iterative remodeling approach is

strongly recommended. The structure of the ABC

rapid prototyping approach is similar to thatused in the pilot approach, but it includes more

areas (ideally, the entire enterprise), more data,

and more analysis. By exposing managers (for

which it is important to select advocates and

avoid nay-sayers or those who may feel threat-

ened) to the quickly produced preview of the

reformed costs, buy-in will occur. Use of this

approach enables an organization to achieve a

new awareness of cost system design through-

out the organization, giving it the ability to rapid-

ly adopt these systems and use the enhanced

information to improve its performance. People

do not know what they do not know. As these

models are iteratively scaled, managers will see

more outcomes that will stimulate what they

want to analyze. Seeing results accelerates this

learning process.

If the initial approach is a pilot ABC study of a

single department or process, then the organiza-

tion should be cautious in that pilots address

only a subset of an organizations activities.

Such an approach faces the danger of overlook-

ing activities or costs from departments, cost

centers, and functions in the organization not

being studied. Activity analysis across multiple

departments, and, ideally, organization-wide, is

preferred by process consultants. Also, compari-

son of the shift in product costs of the existingcosts to ABC costs cannot be done validly by

including only a few departments or attempting

to focus on only one or a few products.

Various questions need to be addressed in the

design and implementation of an ABC system.

One of these relates to ownership of the ABC sys-

tem. While management accountants will calcu-

late the ABC information, in many cases it is

desirable for the system to be owned by others.

The ownership of an ABC system should be con-sistent with its primary objective. If, for example,

improving operations is the primary objective of

the system, it is best placed under the control of

operating personnel. Giving this area ownership

of the system instead of the accounting depart-

ment will help ensure that the system is used

and maintained properly. In practice, however,

this is often a challenge because the accounting

departments role historically has been to col-

lect, validate, and report accounting information

and then analyze it. The result is that the

accounting department typically ends up main-

taining the ABC model.

Another issue that needs to be addressed is the

complexity of the system. In designing a costing

system, there is a trade-off between the cost of

the system and the detail, accuracy, and flexibil-

ity of the system. A guiding principle of ABC is

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that the level of detail and accuracy depends on

what decisions will be made with the information.

The quest for precision is expensive. Ninety-nine

percent accuracy is not required. Those who have

completed an ABC implementation and look back

to compare their previous cost systems inaccu-

rate and flawed costs to their new, more substan-

tially correct costs appreciate why the ABC com-

munity proclaims, It is better to be approximate-

ly correct than precisely wrong! Reasonable

accuracy, produced economically, is usually goodenough, particularly in light of the inaccuracies

from an existing cost system. In general, systems

that support strategic decision making use more

aggregated data than those used for more opera-

tional decision making. The need for additional

accuracy is a long-term issue to be analyzed

based on evolving business needs, and it may be

addressed as the model evolves. In some cases,

data collection can be scaled back as accuracy

requirements and the magnitude of expenses are

better understood.

The question as to whether to integrate the ABC

system with the financial accounting system is

also an issue. ABC systems can be integrated

into the financial accounting system or exist as

stand-alone systems. In many organizations, a

well-designed, periodically updated ABC model

(e.g., quarterly, semiannually) is sufficient for

decision-making needs. An offline ABC imple-

mentation enables these organizations to obtain

improved costing information without disrupting

day-to-day information system activities. This

approach to ABC modeling is especially appropri-

ate for small and mid-sized organizations. It can

also serve as a first step toward implementing

ABC in larger organizations.

In situations where ABC is fully integrated into an

organizations management information sys-

tems, it goes beyond the traditional role of cost

accounting and becomes a primary source of

information for improving business processes

and forward planning. Organizations use the

information as the basis for activity-based man-

agement (ABM); they use the understanding of

their activities and their cost drivers to improve

their processes and enhance their customers

satisfaction. In such cases, data collection is

adjusted to meet the requirements of the ABC

system. The general ledger chart of accounts,

cost center structure, inventory/cost of salesaccounting procedures, interdepartmental

charges, accounts payable and payroll cost distri-

bution practices, financial and management

reports, or other cost-related facets of the

accounting system remain untouched. ABC sim-

ply repurposes the transactional information.

Section XIV discusses commercial ABC software.

In that section, the removal of interdepartmental

charges from the general ledger and their

replacement with proper activity-based costs is

described.

VI I . IN IT IAL DESIGN OF THEABC SYSTEMAn ABC system can be viewed in two different

ways: the cost assignment view and the process

view. The cost assignment view provides infor-

mation about resources, activities, and cost

objects. The process view provides operational

(often nonfinancial) information about business

processes and the activities that belong to them.

These two views of ABC can be visualized as pic-

tured in Exhibit 2.

The cost assignment view of ABC can be seen in

the vertical portion of Exhibit 2, while the

process view is represented by the exhibits hor-

izontal portion. Work activities in the intersection

are essential for both views. For purposes of

measuring costs, the difference is:

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G The cost assignment view transforms the

expenses of resources (e.g., salaries, supplies)

into the costs of the work activities (for both

people and assets) and ultimately into the final

cost objects (e.g., products, customers).

G The process view sequences the work activi-

ties in time and accumulates the build-up of

activity costs from start to end of a business

process.

More about the distinction between these two

views is contained in Section XI, which describes

the process/value stream mapping that ABC

information can supplement. The emphasis of

ABC is typically on the cost assignment view.

Although ABC is the acronym for activity-based

costing, much of the utility from its information

comes from its measurement of the costs of the

diverse types of outputs (cost objects) and the

driver-based consumption of activities they

cause.

The term drivers can be confusing. Resource

drivers for employees reflect the time they spend

performing work activities. Resource drivers for

indirect material purchased items reflect their

usage by an activity, such as energy expenses

kilowatts by a machine. Activity drivers are a

measure of the output of an activity. For exam-

ple, for the customer-related work activity, pro-

cessing a sales order, the activity driver would

be the number of sales orders processed. A cost

object driver is where a final cost object con-

sumes a mix of another final cost object, such as

9


Cost Assignment View (ABC/M) What Things Cost

Better

Decision

Making

Why Things

Have Cost

ProcessView

Resources

Resource Driver

Assignment

ActivitiesCostDriversMeasure and

Manage

Processes

Activity Driver

Assignment

Final Cost

Objects

(Outputs)

Resource

Drivers

Activity

Drivers

EXHIBIT 2. THE ACTIVITY-BASED COST MANAGEMENT FRAMEWORK(THE CAM-I CROSS)

Source: Adapted from CAM-I.


12/35

when a customer purchases a mix of products.

The costing principle for selection of all drivers is

that the level of costs incurred should vary

directly with quantity of the driver.

The term cost driver can be ambiguous. It is

more general than the driver types just

described. It can be described in words but not

necessarily with quantitative measures. For

example, a severe storm is a cost driver that will

cause insurance claims to be processed. One

cannot easily measure a storms intensity, but

you can measure the number of claims

processed that resulted from it. ABC restricts

itself to only measurable resource, activity, and

cost object drivers. Cost drivers are typically

examined in ABC analysis. They are linked to

processes or activities to stimulate discussion

about impact or potential impact. Since cost driv-

ers are generally cross-functional, they often

point to areas of improvement. While cost driv-

ers often are not quantifiable, they often provide

the why when looking at ABC results.

The cost assignment view has evolved from the

two-stage ABC approach of the early 1980s to a

multiple-stage approach. We will first discuss the

two-stage approach to appreciate some funda-

mental principles of ABC, and then discuss the

multiple-stage approach.

Two-Stage ABC Approach

Exhibit 3 illustrates the two-stage ABC approach.

Sub-accounts of the general ledger are distrib-

uted to the various activities in the appropriate

proportions using what were originally called first-

stage cost drivers and now are referred to as

resource drivers. The costs accumulated in these

10


From: General Ledger To: ABC Data Base To: Cost Objects

Chart-of-Accounts View

Claims Processing DepartmentClaims Processing Department

Actual PlanFavorable/

(unfavorable)

Salaries $621,400 $600,00 $(21,400)

Equipment 161,200 150,000 (11,200)

Travel expense 58,000 60,000 2,000

Supplies 43,900 40,000 (3,900)

Use andoccupancy 30,000 30,000 ------

Total $914,500 $880,000 $(34,500)

Key/scan claims $ 31,500

Analyze claims 121,000

Suspend claims 32,500

Receive provider inquiries 101,500

Resolve member problems 83,400

Process batches 45,000

Determine eligibility 119,000

Make copies 145,500

Write correspondence 77,100

Attend training 158,000

Total $914,500

Resource

drivers

#of

#of

#of

#of

#of

#of

#of

#of

$914,500

Activitydrivers

Products/Customers

#of

#of

Activity-Based View

EXHIBIT 3. EACH ACTIVITY HAS ITS OWN ACTIVITY DRIVER



13/35

activities are then distributed to cost objects

using what were initially called second-stage

cost drivers but are now called activity drivers.

For example, costs such as unemployment insur-

ance and equipment maintenance might be allo-

cated to activities based on labor cost and

equipment hours, respectively, based on

resource drivers. Costs accumulated in the vari-

ous activities are then reassigned to products

using activity drivers such as the number of

equipment setups, orders, purchase orders,equipment run minutes, direct labor hours, and

so forth.

The left-side box in Exhibit 3 is the monthly cost

center spending report. An important reason as

to why ABC is being adopted is the realization

that, in this cost center, the responsibility report

using chart of account elements, such as

salaries and supplies, isstructurally deficient in

its ability to transform expenses to calculated

costs. This is a strong statement. But it is not

until the ledger expenses are restated in differ-ent formatas activity coststhat the activity

drivers can be attached to activity costs in order

to reassign them to the activities outputs in pro-

portion to their consumption of the resources.

This problem is compounded as companies flat-

ten and de-layer their organizations. Employees

from cost centers flexibly multitask, often work-

ing jointly on common activities, making the trac-

ing of cost to products (or other cost objects)

more difficult, especially when using a traditional

costing methodology.

In other words, for business process owners

those individuals responsible for the perfor-

mance of business processes that cross multi-

ple cost centersto see the costs of their

processes, activity costs must first be translated

from expenses classified based on the general

ledger. They must be reassembled based on the

activities that make up the sequential steps that

comprise a process. Again, the general ledger

cost center report is structurally deficient to do

this. It has been said that when cost center man-

agers receive their monthly reports comparing

actual to budget (or planned) spending, they are

either happy or sad, but rarely are they any

smarter! ABC information makes them smarter.

A more stinging commentary on the general

ledger-based report is that it is at best useless

(except for collecting transaction data) and atworst leads to dysfunctional and misleading

decisions. The data needs to be transformed

into meaningful costs that reflect cause and

effect behavior.

Note the total expenses and costs are equal in

the resource, activity, and cost object views; they

must reconcile. The important message here is

that the general ledgers view of the chart of

accounts only answers what was spent. By trans-

forming expenses into calculated costs in the

next two views in Exhibit 3, there are more valu-able and useful answers regarding why it was

spent, what caused the rate of it to be spent,

and for whom or what it was spent.

Multiple-Stage ABC Approach

The multiple-stage approach represents an

advancement in ABC modeling. Rather than sim-

ply tracing the cost of resources to activities and

then to cost objects, the multiple-stage approach

models cost flows in a manner that more close-

ly reflects the actual flow of costs through a

organization. This approach includes an under-

standing of the relationships between indirect

work activities and other activities, as well as

between those activities and cost objects. Costs

are traced from activity to activity in a series of

stages, all based on cause-and-effect relation-

ships. (To simplify the size of the ABC model,

some organizations use the concept of resource

11



14/35

pools to accumulate similar expenses into cate-

gories before assigning them to activities.)

For a manufacturing company, the activities per-

forming maintenance and operating the tool

room will accumulate the costs directly related

to those activities. (Note that activities are best

described using an action-verb and noun gram-

mar convention.) Under the two-stage approach,

an activity (or second-stage) driver would be

used to allocate the costs of these activities

directly to cost objects. The multiple-stage

approach differs in that it recognizes that the

maintenance activity is not directly consumed by

the final cost objects. The maintenance activity

supports otheractivities (including some activi-

ties of the tool room). In general, an activity may

directly support both final cost objects and other

activities; the latter are called intermediate cost

objects. The costs accumulated in those activi-

ties are distributed to either final cost objects or

other activities based on the demand for those

activities, services, or resources.

To some, this multiple-stage method of assigning

expenses may appear to be the traditional step-

down cost allocation method of full absorption

costing. ABC is more granular, however, tracing

costs at the activity level and not at a depart-

ment level. The allocation of expenses at a

department level induced errors because it

restricted the allocation basis of those costs to

a single activity driver. As a rule, all assignments

in ABC are based only on usage and consump-

tion. If an activity does not use part of a

resource, it is not allocated any of that

resources costs.

Activity-to-activity cost assignments and an

entire enterprise-wide view of an ABC cost

assignment network are illustrated in Exhibit 4,

where $70 of resource expenses are fully

12


ResourcesResource Expenses

($70)$10 $10 $30 $10 $10

Support

activities

$30

Direct

Material $10

Product

activities $15

Customer

activities $20

$15

$10

$5

$10 $15 $20

Products

$25

Customers

$20

Business

sustaining $25$25

$45 $25$25

External Customers/Orders + Sustaining

$70Price

Final cost

objects

Activities

Cost-driver Table

Resource

drivers

*Inter-

mediate

drivers

Final activity

drivers

*Intermediate activity drivers reassign

each activitys cumulative input costs

plus its own cost.

EXHIBIT 4. MULTI-LEVEL COST ASSIGNMENT FLOW



15/35

absorbed as calculated costs into customer and

business sustaining cost objects (the latter

being traced mainly to senior management).

Note how the $30 of support activities is traced

to three other types of activities, which are then

traced to products, customers, or business sus-

taining cost objects.

Business sustaining costs ($25 in Exhibit 4) are

activity costs not caused by making products or

delivering services to customers. The consump-tion of these costs cannot be logically traced to

products, standard service-lines, channels, or

customers. (They can be arbitrarily allocated, but

not with a causal relationship.) Examples include

the monthly closing books activity of the

accounting staff and file government regulatory

papers activity of the legal staff. The cost of

these activities should be traced to senior man-

agement and the regulatory agency, respectively,

as business-sustaining cost objects. While it is

true that the business must recover these costs

with its revenues, the point is that allocatingthem to products or customers is misleading

and would overstate their costs, sending the

wrong signals to employees who use product

cost information for decision-making purposes.

The cost of customer activities is often called

the cost-to-serve. These activities not only

include examples such as processing sales

orders, call center assistance, and handling

returned items, but also the sales forces activi-

ty making sales calls. This last activity may

appear odd since the customer may not initiate

a sales call, but the purpose of ABC is to meas-

ure how much effort goes into work and where

that work is consumed. An important or difficult,

high-maintenance customer may consume sub-

stantial sales-call-related costs. These costs

may be a greater proportion of the customers

revenues than smaller, less demanding cus-

tomers. ABC measures and detects this type of

not-so-obvious relationship.

Exhibit 4 also shows that some final cost objects

(e.g., the $25 of product costs) can be con-

sumed by other final cost objects that use them.

For example, customers consume (i.e., pur-

chase) uniquely different baskets of products

or services. In this example, the products are

traced using cost object drivers, such as the

number of products purchased. Other examplesinclude the type of order (e.g., special vs. stan-

dard) or type of sales channel (e.g., truck vs. rail,

human bank teller vs. an ATM machine).

Also note that in the exhibit, the price for prod-

ucts and service-lines enters as revenues only

after all of the costs have been assigned. A price

cannot be distinguished as to whether it is for

the product or cost-to-serve costs (unless it is

unbundled separately as a fee). This property

provides the insight that layers of profit contribu-

tion margins (i.e., the profit and loss statementsbottom lines, not top lines) can be reported as

the various work activities ultimately are traced

logically and causally to customers. It must be

understood that ABC deals with cost. Pricing is a

management decision that typically is market

based. What ABC provides is a much more accu-

rate middle line so that the profit margin,

derived from sales less traceable costs, can be

made more visible.

Exhibit 5 disaggregates and expands Exhibit 4 to

reveal a generic ABC structure that is a good rep-

resentation of any universal costing model for

any organization. Note that direct material

expenses are sometimes traced directly to prod-

ucts. A more common modeling practice is to

have direct material expenses touch a pass-

through intermediate cost objects in the Activity

13



16/35

view so that the three cost views equate in terms

of total costs (e.g., they all equal $70 in

Exhibit 4).

To understand Exhibit 5, imagine the cost assign-

ment paths (the arrows) as pipes or straws

where the diameter of each path reflects the

amount of cost flowing. The power of an ABC

model lies in the fact that the cost assignment

paths and their destinations provide traceability

to segment costs from beginning to end, from

resource expenditures to each type of (or each

specific) customerwho ultimately are the origin

for all costs and expenses. The cost assignment

network captures and reflects the diversity and

variation in how cost objects uniquely consume

resources and activities. To understand costing,

it is useful to mentally reverse all the arrow-

heads in Exhibit 5. This polar switch reveals that

all expenses originate with a demand-pull from

customers. The calculated costs simply measure

the effect. Costs are always a measure of

effecta basic principle in costing.

With integrated ABC software, the direct costing

of indirect costs is no longer an insurmountable

problem, as it was in the past. (Commercial ABC

software is discussed in Section XIV.) ABC allows

intermediate direct costing to a local process, an

internal customer, or a required component that

is causing the demand for work. In short, ABC

connects customers to the unique resources

they consumein proportion to their consump-

tion. Visibility to costs is provided everywhere

throughout the cost assignment network.

14


Resources

(general ledger)

Work

Activities

Final

Cost

Objects

Salary, Fringe

Benefits

Direct

Material

Phone,

Travel

Supplies

DepreciationRent,

Interest, Tax

Suppliers

ProductsServices

BusinessSustaining

Customers

SupportActivities

PeopleActivities

cost-to-serve

paths

CostsMeasuretheEffects

(1)DemandsonWork C

osts(2)

DirectM

aterial

EXHIBIT 5. ABC COST ASSIGNMENT NETWORK



17/35

VI I I . STRATEGIC VS.OPERATIONAL COSTMANAGEMENTThere are two broad purposes for using manage-

ment accounting information:

G Strategic cost managementto determine the

right things to do, i.e., selecting the correct

processes, suppliers, products, channels, and

customers.

G Operational cost managementto perform well

on those things identified as strategic, improve

productivity, and remove waste.

This section discusses both forms of cost

management.

Strategic Cost Management

After implementing ABC, organizations typically

experience shock. Their erroneous beliefs

regarding the true profitability of their products,

channels, and customers produced by the flawed

and misleading costs of traditional costing have

been replaced by knowledge of their true costs.

ABC reveals which products are over- or under-

costed, exposing the magnitude of sources of

profits and losses. Exhibit 6 presents a typical

scenario. This diagram is popularly called a

profit cliff.

15


Cumulative Profit (Millions)

NetRevenues

Minus

ABC Costs

$8

$6

$4

$2

$0

Misleading profit data

from traditional cost

allocations.

$ 30.0 sales 28.2 expenses

= $ 1.8 profits

Specific Products, Services, and/or Customers

(ranked most profitable to least profitable)

$1.8 profit

Unrealized profit revealed by ABC

EXHIBIT 6. PROFITABILITY PROFILE USING ABCPROFIT CLIFF



18/35

Insights gained from answering questions that

are stimulated from analyzing the profit cliff

are examples ofstrategic cost management. The

insights can address rationalizing which prod-

ucts, channels, and customers to develop,

acquire, grow, retain, and improveand which

ones not to. But an organization must be careful

not to improperly conclude what actions to take

when analyzing ABC data. Ultimately, manage-

ment accounting, including ABC, is a methodolo-

gy for discovery and focus. Better managementaccounting does not provide all the answers. It

does not answer questions directly, but rather it

allows more and better questions to be asked.

Here are three problems from reacting to ABC

data prematurely:

G It must be recognized that measuring the costs

and profits during a time period such as a

month or quarter does not recognize the costs

and profits of individual products, service lines,

and customers during their entire life cycle.

Hence, servicing an apparently unprofitableproduct or customer today may be done with the

intention of developing a very profitable one in

the future. Life-cycle profitability must also be

analyzed (and ABC unit costs are essential for

such an analysis).

G In some cases, a business will deliberately sell

some products at a loss to promote purchases

of other more profitable ones. Similarly, some

unprofitable customers may be retained or pur-

sued to retain or attract profitable customers

with which they have referral relationships.

Retention of these customers is a management

decision, but it is important to understand how

much these customers are costing the firm.

G Abandoning unprofitable products and cus-

tomers reduces activity costs but not the

expenses of the resourcesit merely frees up

capacity in those resources. To realize a profit

impact from dropping products or customers,

the unused capacity created must either be

filled with new, profitable orders, shifted to per-

form value-added work elsewhere, or altogether

removed (e.g., closing an operation or terminat-

ing employees). The resource cost of freed up

unused capacity created by dropping unprof-

itable products or customers should not be

reassigned in the ABC cost assignment network

to existing products or customers. They did not

cause it. It should be traced to a business sus-

taining final cost object, Unused Capacity.Failure to assign expenses in this way results in

over-costing the existing products and cus-

tomers, giving the illusion they have become

less profitable and, therefore, are new candi-

dates to drop. This has been referred to as the

overhead death spiral. Inappropriate deci-

sions to drop more products or customers due

to prior period removals, sometimes blamed on

the use of ABC, is a result of flawed cost assign-

ment assumptions.

Cost management must always be done in thebroader context of performance management,

which adds the dimensions of time, quality, risk,

service levels, and other strategic goals to maxi-

mize value from existing customers and potential

new ones.

Operational Cost Management

Exhibit 7 illustrates how the activity costs (with

each activity initially traced from its resource

expenses) from Exhibit 6 are assigned to each

cost object and then summed or stacked. In

Exhibit 7, a products true cost is more than its

price, creating a loss during that period. This is

represented by the descending products located

on the right-hand side of the profit cliff depicted in

Exhibit 6.

Managers and employee teams are seeking more

transparency and visibility of their costs. Having

16



19/35

reliable unit costs of their outputs of work using

ABC is useful for benchmarking best practices orto report trends when measuring performance

improvement. Exhibit 7 visualizes how this need

is met. It removes the illusion that overhead

costs are necessary and, therefore, appear to be

free when in fact they are not. The exhibit also

indicates that the costs of a cost object can be

reduced (i.e., lowering the stack) by:

G Reducing the quantity, frequency, and/or inten-

sity of the activity driver (e.g., a fewer number

of inspections reduces the inspect product

activity cost).

G Lowering the activity driver cost rate from pro-

ductivity improvements (e.g., shorten the time

for each inspect product event).

G Understanding the sources and causes of

waste leading to nonvalue-adding activities to

reduce or eliminate them (e.g., solve the

problem that requires an inspection in the first

place).

These three items are examples of how ABC

data leads to operational cost management.

Note how these actions support the continuous

improvement principles of the Six Sigma quality

and Lean management initiatives that are

embraced by the operations and quality commu-

nities. There is further discussion of

process/value stream mapping to improve oper-

ations and quality in Section XI.

ABC Attributes

There is an added bonus to using ABC with com-

mercial ABC software. It can report another

dimension of coststhe color of money spent.

It applies cost attributes, usually to an activity, by

tagging or scoring it with a code. This dimension

of cost does not exist in general ledger account-

ing systems because attributes are tagged to

17


ABC provides insight for the products or services cost drivers and

driver quantities.

$ loss

$

Price/Fee

(Revenue)Activity

Costs

each activitys

driver quantity

Xunit activity

driver cost(e.g., # of registrations)

$

Work

Activities

EXHIBIT 7. FULLY TRACED COSTS TO A COST OBJECT



20/35

activities or to cost objects, not to resource

expenses.

An example of a tag would be whether an activi-

ty adds value (value-adding) or not (nonvalue-

adding). Another example is the five cost of

quality (COQ) categories of work, which

increase sequentially in their severity: error free,

prevention-related, appraisal-related, internal fail-

ure work, and external work. Attributes do not

alter the cost of anything calculated by ABC, butthey facilitate grouping activity costs into various

categories that in turn help focus management

attention (e.g., nonvalue-adding costs) and can

suggest actions. Commercial ABC software can

keep track of a work activitys attributes and

trace it to cost objects. For example, one may

discover that the unit cost of delivering two sim-

ilar service lines is relatively the same, but one

service line consumes much more nonvalue-

adding activity costs than the other. Presuming

operational improvements can reduce the

nonvalue-adding costs, this means that one ser-vice line has a greater likelihood of having a

lower cost in the future. This could never be

detected using the broad-averaged cost alloca-

tions of general ledger cost center reporting.

IX . CUSTOMER PROFITABIL ITYREPORTINGSome customers purchase a mix of mainly low-

margin products. After adding the costs-to-

serve those customers apart from the products

and service lines they purchase, these cus-

tomers may be unprofitable to a company and to

its extended value chain. Customers who pur-

chase a mix of relatively high-margin products

may demand so much in extra services that they

also are unprofitable. How does one properly

measure customer and supplier profitability?

After the less-profitable customers and suppliers

are identified, they need to be migrated toward

higher profits using profit margin management

techniques or, if that is not possible, they need

to be fired.

If two customers purchased the exact same mix

of products and services at the exact same

prices during the exact same time period, would

both customers be equally profitable? Of course

not. Some customers place standard orders with

no fuss, whereas others demand nonstandard

everything, such as special delivery require-ments. Some customers just buy your standard

product or service line, and you hardly ever hear

from them. Others you always hear fromand it

is usually to change their delivery requirements,

inquire about expediting their order, or return or

exchange their goods. Some customers require

more post-sale services than others do. In some

cases, just the geographic location of the cus-

tomer makes a difference.

What kinds of customers are loyal and prof-

itable? Which customers are only marginally prof-itable or, worse yet, losing you money? Strategic

ABC is the accepted methodology to economical-

ly and accurately trace the consumption of an

organizations resource expenses to the types

and kinds of channels and customer segments

that place varying demands on the company. It is

typical to find 10%-20% of your customers are

unprofitable; in some cases the percentage of

unprofitable customers is 40% or more, particu-

larly with banks, where a minority of highly prof-

itable customers carry less-profitable customers

who have the potential to become profitable.

Exhibit 8 decomposes the network of the ABC

Cost Assignment Networks final cost object mod-

ule depicted in Exhibit 5. It displays two layers of

a nested consumption sequence of costs. A

metaphor for this consumption sequence is the

predator food chain. The final cost object, which

18



21/35

in this exhibit is the customer, ultimately con-

sumes all the other final cost object costs, with

the exception of the business sustaining costs.

Each of the major final cost object categories

(e.g., supplier, product/service line, and cus-

tomer) has its own sustaining costs that are

assignable to its end-product or customer. When

tracing these sustaining costs, however, one

cannot apply a measurable product- or customer-

specific quantity. For example, a product branding

program from the marketing department may ben-

efit only a select group of products, but how much

of the branding cost should be charged to each

specific product within the brand? Even though

there is no cause-and-effect relationship, these

product sustaining costs can be traced using

some shared basis, such as sales unit-volume,

or be spread evenly.

As costs flow from one final cost object to anoth-

er, each flow will consume the unique mix of the

upstream cost object. That is, an individual cus-

tomers total costs (apart from its direct costs-to-

serve) are inclusive of only the product quantities

and mix that it purchased. In the ABC cost assign-

ment network, each product incurs its own activi-

ty costs with a cause-and-effect relationship, not

with an arbitrary indirect cost allocation. This

then creates layers of costs that produce many

profit margin layers.

Exhibit 9 is an example of an individual customer

profitability statement. Using ABC, there can now

19


SALARY &

FRINGE BENEFITS

DIRECT

MATERIAL

CAPITAL

(equipment-related)

NON-WAGE RELATED

(e.g., operating supplies)

RELATIONSHIP

MANAGEMENT

PURCHASES,

RECEIPTS

*BRAND/PRODUCT-

RELATED WORK,

*BRAND/PRODUCT-

RELATED ADVERTISING

& MERCHANDISING

*FACILITIES COST

MACHINES

MAKE PRODUCT,

MOVE PRODUCT,

SET-UPS

TRADE SHOWS,

IMAGE ADVERTISINGSALES CALLS,

ORDER HANDLING,

FREIGHT

RESOURCES

WORK

ACTIVITIES

(examples)

FINAL

COST OBJECTS

SUPPLIER

SUSTAINING

UNIT &

BATCH

LEVEL

SUPPLIERS

SUPPLIER-

RELATED

BRAND

SUSTAINING

PRODUCT/SERVICE

LINE SUSTAINING

UNIT &

BATCH

LEVEL

CUSTOMER

SUSTAINING

UNIT &

BATCH

LEVEL

SENIOR

MGT

UNUSED

CAPACITYR&D

# POs

# Receipts

BUSINESS

SUSTAINING

RELATED

ARBITRARY

(for full absorption)

CUSTOMERS CUSTOMER-RELATEDPRODUCT & SERVICE LINE-RELATED

ARBITRARY

(for full absorption)

# Sales calls

# orders

# shipments

OSHA IRS

DOTEtc.

Gvt. Regulators

# Shows

# Advertisements

# Machine hours

# Material moves

# Set-ups

# Punds

# Gallons

# Meters

Facilitycosts

# Advertisements

PRODUCTS/SKUs

Product-specific

EXHIBIT 8. ABC PROFIT CONTRIBUTION MARGIN LAYERING



22/35

be a valid profit and loss income statement for

each customer and for logical segments or group-

ings of customers. A tremendous amount of

detail lies below and within each of these

reports. For example, individual product and ser-

vice lines can be examined in greater detail; they

comprise a mix of high- and low-profit margin

items based on their own unit costs and prices.

In other words, in a customer-specific profit and

loss summary, the product or service-line profit

margin is reported as a composite average, but

details about the mix are viewable by drilling

down into the product mix information. In addi-

tion, the user can drill down further within each

product or service line to examine the content

and cost of the work activities and materials

(the bill of costs).

What does all this information reveal? First, it

quantifies what everyone may already have sus-

pected: All customers are not the same. Some

customers may be more or less profitable based

strictly on how demanding their behavior is.

Although customer satisfaction is important, a

longer-term goal is to increase customer and cor-

porate profitably. There must always be a bal-

ance between managing the level of customer

service to earn customer satisfaction and the

impact that doing so will have on shareholder

wealth. There is a difference between customer-

20


CUSTOMER: XYZ CORPORATION (CUSTOMER #1270)

Sales $$$ Margin $

(Sales Costs)

Margin

% of Sales

Product-Related

Supplier-Related costs (TCO) $xxx $xxx 98%

Direct Material xxx xxx 50%

Brand Sustaining xxx xxx 48%

Product Sustaining xxx xxx 46%

Unit, Batch* xxx xxx 30%

Distribution-Related

Outbound Freight Type* xxx xxx 28%

Order Type* xxx xxx 26%

Channel Type* xxx xxx 24%

Customer-Related

Customer-Sustaining xxx xxx 22%

Unit Batch* xxx xxx 10%

Product-

related

costs

Customer-

related

costs

Business Sustaining xxx xxx 8%8% Operating Profit

Capital Charge** xxx xxx 2%

(inventories, receivables) 6% Economic Profit(for EVA)

* Activity Cost Driver Assignments use measurable quantityvolume of Activity Output(Other ActivityAssignments traced based on informed (subjective) %s)

**Capital charges can also be directlycharged as imputed interest to products& cust.

EXHIBIT 9. ABC CUSTOMER PROFIT & LOSS STATEMENT



23/35

focused and customer-obsessed. The best solu-tion is to increase customer satisfaction prof-

itably. Because increasingly more customers will

expect and demand customization rather than

standard products, services, and orders, under-

standing this balance is important. ABC data

facilitates discussions aimed at arriving at that

balance.

There are two major layers of profit margin in the

company profit and loss statement in Exhibit 9:

1. Mix of products and service lines purchased,

and

2. Costs-to-serve apart from the unique mix

of products and service lines.

Exhibit 10 provides a two-axis view of customers

with regard to these two major layers. Any single

customer (or cluster) can be located based on

these two attributes. The vertical axis measures

the composite margin of what each purchases(reflecting net prices to the customer), and the

horizontal axis measures a customers costs-to-

serve. Exhibit 10 debunks the myth that the

company with the highest sales must also gener-

ate the highest profits.

Exhibit 10 also reveals that the objective is to

make all customers more profitable, graphically

represented by driving them to the upper-left cor-

ner. Although this is a partial list, making cus-

tomers more profitable can be accomplished by:

G Managing each customers costs-to-serve to

a lower level;

G Establishing a surcharge for or re-pricing

expensive costs-to-serve activities;

G Reducing services;

G Raising prices;

G Increasing costs on activities that a customer

shows a preference for;

21


Types of CustomersVery

Profitable

Very

unprofitableCost-to-Serve

Product MixMargin

High

(Creamy)

Low

(Low Fat)

Low

Profita

ble

Unprofita

ble

High

EXHIBIT 10. MIGRATING CUSTOMERS TO HIGHER PROFITABLITY



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G Shifting the customers purchase mix toward

richer, higher-margin products and service

lines; or

G Discounting to gain more volume with low

costs-to-serve customers.

An extreme action is to fire the customer

terminate the relationship when one concludes it

will never be a profitable relationship.

Note that migrating customers to the upper-leftcorner is equivalent to moving customers from

right to left in the profit profile in Exhibit 6.

Knowing where customers are located on the

matrix requires ABC data. Changes can be made

only by knowing the activity detail behind the

numbers.

X. ABC PROJECT PLANNINGOnce questions involving the initial ABC model

design and construction are answered, planning

for the ABC project can move forward. Like any

major organization-wide systems project, a for-mal project management structure and project

plan is necessary for an effective implementa-

tion. The structure should include a steering

committee composed of upper management

whose main role is to ensure that the ABC sys-

tem is consistent with the organizations busi-

ness strategy and needs and to ensure that

there is participation and cooperation from all

affected areas of the organization. The project

manager reports to the steering committee and

is supported by a cross-functional team. The size

of the team and level of involvement of the vari-

ous members would depend on the specifics of

the project. The important point is that all affect-

ed functions of the organization must participate

in the development and implementation of the

ABC system in order to foster buy-in and commit-

ment throughout the organization and to improve

its design.

An important element of a successful implemen-

tation of ABC is training. Although it is not nec-

essary for management to become ABC experts,

they must understand the need for ABC, its ben-

efits, and its key concepts. On the other hand,

members of the project teamthose actually

designing and implementing the systemdo

need to develop a thorough understanding of

both the hows and whys of ABC. Because

ABC is as much an art as it is a science, it is not

enough to master the mechanics. The designersand implementers must comprehend the various

approaches and the levels of scope, accuracy,

and detail that will result in the most cost-

effective system for their particular organization.

Those who will be providing data input for the

system, both during its development stages and

its ongoing execution as a repeatable reporting

system, must understand the significance of the

data they provide.

Finally, the system will not be effective unless its

users understand the new information that ABCprovides. At some organizations, ABC will contra-

dict many of the beliefs about the organizations

costs and profit margins. For example, most

manufacturing firms have believed for decades

that direct labor efficiency was the key measure-

ment of productivity. Under ABC, many of these

firms found that direct labor may be an immate-

rial component of the cost equation relative to

indirect expenses, and focusing on direct labor

efficiency drew attention away from important

issues. The project team must ensure that every-

one involved understands the new systems out-

put and how it can best be put to use in improv-

ing the organizations operations.

XI . COLL ECTING ABC DATATwo types of information are required for an ABC

project: conceptual and transactional.

Conceptual information is needed to develop the

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overall design of the ABC system, and transac-

tional information is needed to simulate the cost

flows through the system model. Transactional

information also serves as the raw data from

which to develop and validate some of the con-

ceptual information.

The goal of the data-gathering activity is to accu-

mulate the necessary information to:

1. Identify the work activities performed by peo-

ple and equipment in the organization (forboth the cost assignment and process

views);

2. Identify the organizations elements of cost

(for the cost assignment view) and perfor-

mance measures (for the process view);

3. Determine the relationships between the

various activities and elements of cost (for

the cost assignment view); and

4. Identify and measure the activity drivers that

determine the work load (for the process

view) and cause accumulated activity costs

to flow to other activities or to the organiza-tions products and services (for the cost

assignment view).

1. Identifying Work Activities

Even a small organization can identify an almost

limitless number of activities. The work activity

identification exercise, however, should be guid-

ed by materiality and the objectives of the ABC

system. For example, if the objective is strategic

(e.g., product line profitability, pricing policies),

the primary need is to accurately assign costs to

final cost objects. In such cases, activities can

be broadly defined. If the intent is to improve

operations (e.g., eliminate nonvalue-added

processes), however, the need is for information

about work activities and intermediate cost

objects. For example, in a purchasing depart-

ment, what is the difference between the unit

costs of a special order vs. a standard order vs.

a blanket purchase order? What activity costs

comprise each, and what activity drivers cause

each? In these cases, activities must be defined

more narrowly.

Materiality will also impact activity aggregation

definitions. For example, an organization with

only two individuals in the purchasing function

will not gain as much by dividing the function into

20 separate activities as will an organization

with 50 individuals.

2. Identifying Elements of Cost

Elements of cost are the expenses of the organi-

zations resources, including labor salaries and

expenses of capital, machinery, buildings, mate-

rials, supplies, equipment, and utilities. An orga-

nizations general ledger is typically the source of

information about these cost elements, but it

does not break those cost elements down by

activity performed. That is why ABC reassigns

those resource expenses into activity costs

using resource drivers.

3. Determining the Relationship between

Activities and Elements of Cost

The ABC system designer must assign the

expense data contained in the general ledger to

activities. This assignment is determined by the

relationships between the various work activities

and the elements of cost. Mentioned earlier as

an optional design, some ABC models first group

similar expenses into categories or jobs, referred

to as resource pools. The elements of cost or

resource pools can be assigned to activities by

assigning them in some directly measurable

manner (e.g., metering electric consumption,

charging maintenance via a work order, charging

requisitioning activities for supplies) or through

estimation (as determined through question-

naires and interviews).

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Arbitrary cost allocations, particularly those

using broad averages, should be minimized

whenever possible. This is because they do not

improve the understanding of the economics of

performing activities. In addition, over-averaging

the allocations distorts the costs of cost objects

by over-costing some while under-costing others.

(Remember that for past period costing, there

must be zero-sum errors.)

4. Identifying and Measuring ActivityDrivers

Activity drivers are the usage-based variables that

explain the behavior and magnitude of activity

costs. They reflect the consumption of expenses

by activities and the consumption of activities by

other activities, products, or services.

The quest for precision tempts ABC system

designers to select too many excessively

detailed activities (effectively, tasks), each of

which will require an activity driver. Decisions

must be made as to the trade-offs between high-er accuracy and administrative effort, as well as

the difficulties of operating a more complex cost-

ing system.

Sources of ABC System Information

There are three primary sources for the informa-

tion needed to develop an ABC system: people,

the general ledger, and the organizations infor-

mation technology (IT) systems.

1. The people who perform the work can pro-

vide information about the organizations

activities, the resources consumed, and the

performance measures used.

2. The general ledger provides information

about an organizations elements of cost. In

some cases, the ABC system can directly

extract data from the payroll and accounts

payable systems that are summarized in the

general ledger system.

3. IT systems provide data that measures the

outputs produced. Collectively, the organiza-

tions IT systems should contain information

about most of the cost objects and the

resource and activity cost drivers. For exam-

ple, the number of invoices paida potential

activity drivershould be available from the

accounts payable system.

Including representatives from the IT function on

the cross-functional ABC project team can help inthe determination as to whether the required

information is already available in the transaction-

al and other IT systems. This will facilitate captur-

ing and processing of information. Some of the

data used in developing the ABC system, howev-

er, will come from interviews and questionnaires

directed to the organizations personnel because

they are the best source of this information.

It is important that the ABC project team be rea-

sonable in its determination regarding the level

of detail needed to design the system properly.Knowledgeable estimates of the relevant items

are preferable to precise calculations of irrele-

vant ones. As a result, team members must not

become too focused on details and should keep

the concept of materiality and Paretos 80-20

rule (80% of an outcome can be explained by

20% of all the information potentially available)

in mind at all times.

The interview process can be supplemented with

tools such as process mapping and value

chain/stream analysis, which help to document

the results of the data collection process and

organize the information to ensure it is com-

plete, understandable, and can be readily ana-

lyzed. As mentioned in Section VII, these tools

are embraced by the operations and quality com-

munities to remove waste, focus on value-adding

work, and improve productivity.

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Value chain/stream analysis, as it relates to

activity-based costing, requires the subdivision ofan organizations processes into its distinct strate-

gic activities. Basically this is the disaggregation

of the end-to-end business processes into the

work activities that belong to each of them. These

activities provide the building blocks by which the

organization creates value for its customers.

Leveling business processes to a useful level of

detail can be a challenge, and accountants tend

to excessively disaggregate them. Disaggregating

is the result of refining the verb-noun grammar of

an activity. For example, the activity process

invoices can be disaggregated into process

domestic invoices and process international

invoices. For ABCs purpose, the amount of time

and cost for each will sum to the higher aggre-

gate, but dividing them provides better structure

to trace each activity using its own individual

activity driver. The result will be a more accurate

distinguishing of the unit cost of processing a

domestic invoice relative to an internationalinvoice (where the latter is likely be a higher unit

cost due to the extra steps involved). Without dis-

aggregating the unit cost per processed invoice

for each type, the result will be an average unit

cost for the two types. ABC is in effect a de-aver-

aging technique. At some level, however, the

insights gained and the increased cost accuracy

is not worth the effort. Typically, you do not want

to divide activities into their tasks. Keep in mind

that the level of detail and need for accuracy

depends on the decision for which cost data is

needed.

Strategic work activities should be considered

distinct and, therefore, isolated if they represent

a significant percentage of operating cost, the

behavior of their cost is unique, they are different

from the activities performed by competitors, or

25


Resources

Work Activities are

CENTRAL to processes and

stakeholders.

Dept. 1

xxxxxxx

xxxxxxxxxxxxxx

xxxxxxx

xxxxxxx

Dept. 2

xxxxxxx

xxxxxxxxxxxxxx

xxxxxxx

xxxxxxx

Dept. 3

xxxxxxx

xxxxxxx

xxxxxxx

xxxxxxx

xxxxxxx

Process Measures

$

x = activities

= process

= cost drivers

Outputs

EXHIBIT 11. PROCESS VIEW



28/35

they have potential for differentiating the product

or services in the market place.2

Process mapping sequences the activities across

time. It does not involve reassigning those activi-

ties into their final cost objectsthe bottom of

the three cost views in Exhibit 5. ABC does that.

In contrast, durin

implementing activity based costing

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